Business Finance Q: Please compare the advantages and disadvantages of the following investment rules: Net Present Value (NPV), Payback Period, Discounted Payback Period, Internal Rate of Return (IRR) and Profitability Index (PI). (You can start by considering the following questions for each investment rule: Does it use cash flows or accounting earnings? Does it consider all cash flows or not? Does it apply a proper discount rate? Whether the acceptance criteria are clear and reasonable? In what situation it can be applied? What kind of weakness does it have? (10 points) A: Net Present Value is a method to evaluate a project value. NPV requires an estimate of the cost of capital. Therefore, to understand what is NPV, Discount rate should be completely understand. The first advantage is that NPV gives important to the time value of money. Secondly, in the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered. Thirdly, profitability and risk of the projects are given high priority. Fourth, NPV helps in maximizing the firm’s value.
On contrary, NPV is difficult to use. Also, NPV cannot give accurate decision if the amount of investment of mutually exclusive projects are not equal. One difficulty would be calculation of appropriate discount rate. Meanwhile, NPV may not give correct decision when the projects are of unequal life. It could be applied in the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV).
NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Firstly , payback period is very simple to calculate. It can also be a measure of risk inherent in a project. Since cash flows that occur later in a project’s life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. It could be applied while companies facing liquidity problems, payback period provides a good ranking of projects that would return money early. However, payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions.
A variation of payback method that attempts to remove this drawback is called discounted payback period method. One other disadvantage would be the cash flows that occur after the payback period without taking into account. Discounted Payback Period is a capital budgeting procedure used to determine the profitability of a project. In contrast to an NPV analysis, which provides the overall value of an project, a discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure. Future cash flows are considered are discounted to time “zero. This procedure is similar to a payback period; however, the payback period only measure how long it take for the initial cash outflow to be paid back, ignoring the time value of money. Although the discounted payback period calculation is still widely used by managers as they like to know when they will recoup their initial investment, it has three major flaws: First, Time value of money is not considered when you calculate payback period. In other words, no matter in what year you receive a cash flow, it is given the same weight as the first year.
This flaw will cause managers to overstate the time to recovery for theinitial investment. A second flaw is the lack of consideration of cash flows beyond the payback period. If the capital project lasts longer than the payback period, then cash flows the project generates after the initial investment is recovered are not considered at all in the payback period calculation. The third, and perhaps most important, flaw is that discounted payback period does not really give the financial manager or business owner a solid decision criterion upon which to make an investment decision.
In other words, since the business has to guess at the interest rate or cost of capital and because of the first two flaws of this capital budgeting method, it is not the best method to use to choose an investment project. It is a bit better than payback period since the cash flows are discounted. This third flaw of the discounted payback period can be dismissed if the weighted average cost of capital is used as the rate at which to discount the cash flows. In contrast, There are only two real advantages for a business owner to use discounted payback period as a capital budgeting decision criteria.
First, owners and managers like regular payback period to know how long it will take them to recover their initial investment. Using discounted payback period simply gives them a more finely tuned estimate of that. Second, discounted payback period has an advantage over regular payback period for that very reason – cash flows are discounted and calculation gives a better estimate of payback period. Internal Rate of Return is that method of capital budgeting in which we can calculate IRR and compare it with cut off rate for selecting any project.
It has following advantages and disadvantages. Firstly. It is perfect use of Time Value of Money Theory. Time value of money means interest and it should high because we are sacrifice of money for specific time. IRR is nothing but shows high interest rate which we expect from our investment. So, we can say, IRR is the perfect use of time value of money theory. The second point is all cash flows are equally important. It is good method of capital budgeting in which we give equal importance to all the cash flows not earlier or later.
We just create its relation with different rate and want to know where is present value of cash inflow is equal to present value of cash outflow. Thirdly, if there is only project which we have to select, if we check its IRR and it is higher than its cut off rate, then it will give maximum profitability to shareholder. Fourth, in this method, we need not to calculate cost of capital because without calculating cost of capital, we can check the profitability capability of any project. However, there are some disadvantages of Internal Rate of Return.
Firstly, It is difficult to understand it because many student can not understand why are calculating different rate in it and it becomes more difficult when real value of IRR will be two experimental rate because of not equalize present value of cash inflow with present value of cash outflow. Secondly, for calculating IRR we create one assumption. We think that if we invest out money on this IRR, after receiving profit, we can easily reinvest our investments profit on same IRR. We seem to be unrealistic assumption. Last but not least, it is not helpful for comparing two mutually exclusive investments.
Profitability Index is the ratio of Cash inflow to initial investment of a project. This method tells whether an investment increases the firm’s value. Also, it considers all cash flows of the project. And it considers the time value of money. Fourth, it considers the risk of future cash flows (through the cost of capital, therefore, it is useful in ranking and selecting projects when capital is rationed. However, it requires an estimate of the cost of capital in order to calculate the profitability index and it may not give the correct decision when used to compare mutually exclusive projects.